DIP Financing: A Rough Road to Recovery

Alarna Carlsson-Sweeny, PLC

With more companies entering Chapter 11, the demand for DIP (debtor-in-possession) financing is high. DIP financing provides funds for companies in bankruptcy to allow them to maintain operations while they reorganize. However, with less credit now available in the loan market generally, the pool of traditional lenders willing to provide DIP financing has shrunk. As a result, some companies are even adopting strategies to avoid the need for DIP financing. For example, Tribune Company and Nortel Networks Corporation filed "preemptive" Chapter 11 petitions before they ran low on cash.

Debtors are being forced to accept more expensive loans.

Loan maturities are shorter and loan terms are more onerous and lender-friendly.

Courts are reluctantly approving arrangements that make DIP financing more attractive to lenders, such as roll-ups.

Debtors are under pressure to plan their bankruptcy exit strategy more carefully.

Ensuring adequate liquidity is an essential part of a Chapter 11 reorganization case. Because lenders are generally reluctant to extend credit to financially troubled companies, the Bankruptcy Code ( www.practicallaw.com/7-382-3256) is designed to encourage creditors to lend to debtors using DIP financing. For more background and an overview of the various forms of DIP financing, including the advantages and disadvantages of providing DIP financing, see Box, What is DIP Financing? . Practice Note, DIP Financing: Overview ( www.practicallaw.com/1-383-4700) and Timeline of DIP Financing Process ( www.practicallaw.com/9-383-6738) .

New Players in DIP Market

While the post-credit crunch DIP financing market has been largely shut, there have been some limited signs in the last few months that the DIP market is opening up again, particularly with asset-based lenders. However, according to Shannon Lowry Nagle, a partner at O'Melveny & Myers LLP, "Loans are being scrutinized very carefully and those lenders that are left in the market are being very selective about where they place their money."

In the current market, most DIP financings are defensive DIPs ( www.practicallaw.com/8-386-2266) . Richard Levin, a partner at Cravath, Swaine & Moore LLP, says that, "It is hard to know if the DIP market itself is opening up or if it just appears that way because existing lenders and customers are stepping in and providing financing to protect their respective positions." Existing lenders are incentivized to provide DIP loans because of the opportunity to improve their position in the capital structure and have a greater influence over the company's future in a restructuring (see Roll-ups ). Customers of the debtor have an interest in the company remaining operational to ensure availability of their supply.

The holders of existing debt are not necessarily the original lenders. One of the characteristics of the market recently has been the entry of new players, such as hedge funds and private equity funds, who are typically motivated by the prospect of high yields or the desire to acquire distressed companies. After purchasing existing debt on the secondary market, hedge funds and private equity funds are providing DIP financing as holders of prepetition debt, allowing them to take advantage of roll-up arrangements (see Roll-ups ). “Funds have realized that there are opportunities to make good money in the DIP market. Unlike traditional lenders, they are attracted to more than just high fees and interest. Many are taking an active role in restructuring and managing companies through acquiring equity stakes,” says Nagle (see Equity Stakes ).

There are certain advantages for the debtor in having a hedge fund or private equity lender as opposed to a traditional lender. Funds can often process and approve loans more quickly, and may require less disclosure from the debtor. They generally have a higher tolerance for risk and may offer more innovative and creative deal structures.

Higher Priced Loans

"Three or four years ago there was heated competition among lenders to provide DIP loans, but now debtors do not have the luxury of running an auction," says Marshall Huebner, partner at Davis Polk & Wardwell LLP. "Less competition means that the players who are willing to lend can charge a premium for doing so."

The overall cost of DIP loans is higher now not just because of the tight capital supply, but also because of the increased risk that companies may not successfully emerge from bankruptcy. "The current economic climate is full of unknowns, and lenders increase interest rates and fees to compensate for the risk," says Huebner.

By some estimates, interest rate pricing on DIP loans is in the range of LIBOR ( www.practicallaw.com/0-382-3580) (London Interbank Offered Rate) plus 1,000 basis points, compared to 400 to 750 basis points over LIBOR in 2008. However, there are signs that pricing has come down a fraction from its highest point. In addition, LIBOR floors have become almost universal. LIBOR floors operate to keep the base LIBOR rate on DIP loans no lower than 3% or 4%, even if the LIBOR rate drops further.

DIP fees (arranging and exit fees) have also risen to the range of 300 to 450 basis points (up from their previous level of 150 to 250 basis points), and often include up-front and annual fees. In an emerging trend, lenders sometimes insist that the fees attached to DIP loans be kept confidential, claiming this is commercially sensitive information. For example, the bankruptcy courts granted such requests in both the Tribune Company and Circuit City Stores Inc. bankruptcies in late 2008.

Loan Terms: Less Flexibility and Shorter Maturities

Because they are perceived as high risk, DIP loans have always been characterized by their lender-friendly terms. However, in the last year, loan terms have become even more onerous, allowing for less flexibility for the borrower. Examples include more frequent reporting requirements, tougher restrictions on use of collateral, reduced advance rates, tighter coverage ratios and shorter loan maturities.

Typically, DIP loans would have a maturity of 12 to 24 months, to cover the debtor through its period in Chapter 11. Now loan maturities are more likely to be six to 12 months, with some being offered for an even shorter duration.

Nagle says there has since been a push back from judges and debtor's counsel in relation to loan maturities of less than six months, which is simply not long enough in most cases for the debtor to achieve anything. "Excessively short loan maturities tie up the debtor in worrying about securing more DIP financing when it should be concentrating on how to reorganize and exit bankruptcy. Where possible, judges are starting to push for loans around the 12-month mark," she says.

The terms of the DIP loan vary depending on who is providing the financing. For example, where a customer is providing the DIP financing, the customer wants to ensure that a resolution happens quickly so the supply of the company's product or service is not interrupted. According to Levin, "If the debtor is a retail debtor,

lenders will have other concerns, namely, reaching a resolution before the deadline for assuming or rejecting the debtor's real property leases." This was a factor in the bankruptcy of Circuit City, in which the debtor had to break 304 leases in late 2008 after a planned auction of the leases failed due to insufficient bidders.

"Beyond the factors that are specific to individual lenders, everyone is still nervous about the economy so few are comfortable lending long term," says Levin.

One of the consequences of shorter loan maturities and less flexible terms is that companies are not entering Chapter 11 unless they have an exit plan in place. Exit plans vary from liquidations and large-scale asset sales to prepackaged and pre-arranged bankruptcies, all of which reduce the amount of time spent in Chapter 11 (see Exit Strategies ).

Roll-ups and Equity Stakes

Obtaining DIP financing can also be harder in the current market because many companies have already pledged all or nearly all of their assets to secure existing loans. If there are no unencumbered assets available, many lenders will not provide DIP loans without a priming lien ( www.practicallaw.com/4-383-2771) or a superpriority claim (which generally supersedes all other liens and claims in the capital structure (see Practice Note, Order of Distribution in Bankruptcy: Priming Lien for DIP Financing ( www.practicallaw.com/7-383-1336) )). In addition to courts increasingly approving DIP loans with priming liens, they are more willing to approve roll-ups of prepetition debt. Lenders are also more commonly providing DIP financing as a strategy to acquire equity ownership.

Roll-ups

A roll-up allows the debtor to apply the proceeds of the DIP financing to satisfy prepetition debt or deems select prepetition debt to have the status of a DIP loan, and is a mechanism designed to encourage existing lenders to provide new financing. Funds lent prepetition are transformed (or "rolled up") into funds lent under the DIP loan and secured by the priming lien or subject to a superpriority claim (as the case may be). "Roll-ups are a way for existing lenders to improve their position in the debtor’s capital structure," says Huebner. "Typically courts will approve roll-ups only if there are no other options to procure the funds to keep the company operational."

This was the case with, for example, Lyondell Chemical Co, which received over $8 billion in DIP loans in January 2009. In a typical defensive DIP, new funds and the rolling up of existing debt are spread equally among the lenders. The Lyondell loan was unusual because some existing lenders were given the chance to put in even more new money for the DIP and to roll up more existing debt which, controversially, made more of their prepetition debt senior to other lenders of the same class.

According to Nagle, the use of roll-ups is fraught with contentious bankruptcy law issues: "One of the principles of Chapter 11 is that any DIP financing must provide 'adequate protection' to other lenders. There are serious questions about whether a lot of these loans containing roll-ups actually do that." Nagle adds though that providing adequate protection for existing lenders can be a difficult task given the poor shape of many debtor company finances.

Also, objectors have alleged that roll-ups violate the Bankruptcy Code's distribution scheme by effectively elevating the priority position of prepetition debt to equal that of new postpetition debt.

Equity Stakes

One strategy adopted by hedge funds and private equity investors active in this market is loan-to-own ( www.practicallaw.com/8-386-2450) . Typically the fund provides DIP financing in exchange for an equity stake in the company when it emerges from bankruptcy (or for control over the asset sales process, giving it an advantage over other potential bidders in an auction of the debtor's assets).

For more about the loan-to-own strategy and the hurdles associated with investing in distressed companies, see Article, Distressed Debt Investing: A High Risk Game ( www.practicallaw.com/9-386-1346) .

Exit Strategies

According to Huebner, "It is important for debtors to have an articulated and consistent strategy outlining how they will emerge from bankruptcy. Obviously the main thing a lender is looking for is that the DIP loan will be repaid."

Nowadays most companies seek to avoid filing for bankruptcy unless they have at least the outline of an exit plan in place. Traditionally, exiting bankruptcy meant confirming a reorganization plan and coming out reorganized. However, there has been a trend towards asset sales under Section 363 of the Bankruptcy Code or plans of reorganization that include a going concern sale (for an overview of the Section 363 sale process, see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview ( www.practicallaw.com/1-385-0115) ). The operating part of the company is acquired and continues operations free of the bankruptcy court, even though the shell remains in bankruptcy. Levin explains: "There are not many traditional reorganizations in bankruptcy, though there have been a few recently, mainly where the company is overleveraged but does not have fundamental operational problems. There have also been some pre-packaged plans in Chapter 11, which are good examples of companies reorganizing and coming out with a repaired balance sheet." For an overview of pre-packaged plans, including a discussion of its advantages and disadvantages, see Practice Note, Bankruptcy: Overview of the Chapter 11 Process: Prepackaged (or "Prepack") ( www.practicallaw.com/4-380-9186) .

When a company comes out of bankruptcy, it typically obtains an exit facility to repay the DIP loan, pay creditors' claims under the reorganization plan and fund its ongoing operations after bankruptcy. "The market for exit financing largely mirrors the market for DIP financing," says Huebner. "Exit financing is often a rollover of existing debt or a conversion of debt to equity, so you see many of the same players that were involved in the DIP financing."

There can be a higher level of risk for new lenders that provide exit financing as exit loans do not provide as much protection for the lender as DIP loans. However, this risk is offset by the fact that the emerged company has usually been stripped of liability and its financial situation and operations thoroughly exposed through bankruptcy disclosure requirements.

What is DIP Financing?

DIP financing is generally approved by the court at the beginning of a bankruptcy case and provides the debtor with immediate access to cash to satisfy ongoing working capital needs while it reorganizes under Chapter 11 of the Bankruptcy Code. As lenders are reluctant to extend credit to financially troubled companies, especially those in the bankruptcy process, the rules relating to the order in which claims are paid in bankruptcy are favorable to lenders who provide DIP financing. For example, lenders may be given a superpriority claim (allowing them to be paid ahead of all other administrative claims) or a priming lien (on property subject to existing liens).